[Note: Miller & Chevalier filed a brief in this case on behalf of National Trust for Historic Preservation]

In a detailed 85-page opinion, the Third Circuit has reversed the Tax Court’s opinion that upheld a claim for historic rehabilitation tax credits by the private partner in a public/private partnership that rehabilitated a historic property on the Atlantic City boardwalk. See our earlier report here. The government had argued both that the transaction lacked economic substance and that the private partner, Pitney Bowes, was not a bona fide partner in the enterprise. The Third Circuit agreed with the government’s second argument and therefore found it unnecessary to decide whether there was economic substance. Given that approach, the court stated that it would “not opine on the parties’ dispute” on whether the Ninth Circuit was correct in Sacks v. Commissioner, 69 F.3d 982 (9th Cir. 1995), in stating that the policy of providing a rehabilitation credit as a tax incentive is relevant “in evaluating whether a transaction has economic substance.” Slip op. 54 n.50. The court did make some general observations on economic substance, however, noting its agreement with amicus that the government’s position had inappropriately blurred the line between economic substance and the substance-over-form doctrine, which are “distinct” doctrines. Slip op. 52 n.50. Citing Southgate Master Fund, L.L.C. v. United States, 659 F.3d 466, 484 (5th Cir. 2011), the court added that “even if a transaction has economic substance, the tax treatment of those engaged in the transaction is still subject to a substance-over-form inquiry to determine whether a party was a bona fide partner in the business engaged in the transaction.” Slip op. 53 n.50.

Turning to the issue that it found dispositive, the court concluded that Pitney Bowes was not a bona fide partner because it “lacked a meaningful stake in either the success or failure of [the partnership].” Slip op. 85. In reaching that conclusion, the court relied heavily on two recent court of appeals’ decisions, the Second Circuit’s analysis of bona fide equity partnership participation in TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006) (“Castle Harbour”) and the Fourth Circuit’s analysis of “disguised sales” in Virginia Historic Tax Credit Fund 2001 LP v. Commissioner, 639 F.3d 129 (4th Cir. 2011). Although the taxpayer had objected that the latter case was irrelevant because no disguised sale issue was present, the court agreed with the government’s argument in its reply brief that “the disguised-sale analysis in that case ‘touches on the same risk-reward analysis that lies at the heart of the bona fide-partner determination.’” Slip op. 67 n.54 (quoting U.S. Reply Br. 9). See our previous report here. The court elaborated on this point as follows: “Although we are not suggesting that a disguised-sale determination and a bona fide-partner inquiry are interchangeable, the analysis pertinent to each look to whether the putative partner is subject to meaningful risks of partnership operations before that partner receives the benefits which may flow from that enterprise.” Id. at 69 n.54.

The taxpayer had relied heavily on the Tax Court’s findings regarding the essentially factbound question of bona fide partnership, but the Third Circuit found that the deferential standard of review of factual findings was not an obstacle to reversal. The court first stated that “the record belies” the Tax Court’s conclusion that Pitney Bowes faced a risk that the rehabilitation would not be completed. Id. at 73. To deal with the standard of review, the court of appeals drew a hair-splitting distinction between the factual issue of “the existence of a risk” and what the court believed to be a “purely . . . legal question of how the parties agreed to divide that risk,” which “depends on the . . . documents and hence is a question of law.” Id. at 73 n.57. The court of appeals directly rejected other Tax Court findings regarding risk as “clearly erroneous.” Id. at 76.

The court did not dwell on the policy implications of its decision. It stated that it was “mindful of Congress’s goal of encouraging rehabilitation of historic buildings” and had not ignored the concerns expressed by the amici that a ruling for the government could “jeopardize the viability of future historic rehabilitation projects.” Id. at 84. But the court brushed aside those concerns, taking comfort in the response of the government’s reply brief that “[i]t is the prohibited sale of tax credits, not the tax credit provision itself, that the IRS has challenged.” Id. at 85. Be that as it may, decisions like this are likely to diminish the practical effectiveness of the credit as an incentive and thus to frustrate to some extent Congress’s desire to encourage historic rehabilitation projects.

The taxpayers have appealed to the Fifth Circuit from the Tax Court’s decision in Rodriguez v. Commissioner, No. 13909-08 (Dec. 7, 2011), which rejected qualified dividend treatment for certain amounts included in their income pursuant to Code Section 951. In 2003, Congress established a preferential tax rate for “qualified dividend income,” which includes dividends received from a qualified foreign corporation. Separately, section 951 contains provisions designed to limit tax deferrals by a “controlled foreign corporation” (CFC). Section 951 requires a taxpayer to include in income earnings of a CFC that are derived from investments in U.S real estate. The taxpayers in this case included such earnings in their income but sought to have them taxed at the favorable qualified dividend rate. In a comprehensive opinion, the Tax Court held that they were not “dividends” and hence should be taxed as ordinary income.

The taxpayers’ position was largely policy-based, arguing that the effect of the income inclusion was similar to that of a dividend, but their argument lacked strong direct support in the statutory text. As the Tax Court noted, legislative history and case law had described the section 951 inclusions as substantially equivalent to receiving dividends. See, e.g., Gulf Oil Corp. v. Commissioner, 87 T.C. 548, 571 (1986) (“Subpart F treats the amount of the increased investment much like a constructive dividend to the U.S. shareholders”). But the Tax Court concluded that this similarity did not resolve the case, observing that “to say that section 951 treats a CFC’s investments in U.S. property ‘much like’ a constructive dividend is a far cry from saying that such amounts actually constitute dividends.”

Instead, the Tax Court focused on a textual analysis. First, the court said that the section 951 inclusion did not meet the statutory definition of a dividend (Code section 316(a)) because there was no “distribution” by the corporation; a distribution cannot occur unless there is a “change in ownership of corporate property.” The court noted that the Code expressly provides that section 951 inclusions should be treated as a dividend for certain other purposes, but there is no such express provision for qualified dividend rates. See I.R.C. §§ 851(b), 904(d)(3)(G), 960(a)(1). The court also pointed to several provisions directing that other kinds of non-dividend income, such as redemptions and undistributed foreign personal holding company income, should be treated as dividends. See, e.g., I.R.C. §§ 302(a), 551(b). Given these examples of explicit dividend treatment elsewhere in the Code, the Tax Court concluded that the lack of an explicit textual basis for dividend treatment was a fatal flaw in the taxpayers’ position.

The Tax Court acknowledged that the taxpayers’ position drew support from the original 1962 Senate Report, which explained that, under Subpart F, “earnings brought back to the United States are taxed to the shareholders on the grounds that this is substantially the equivalent of a dividend being paid to them.” S. Rep. No. 1881, 87th Cong., 2d Sess. 794 (1962). But the court found that this sentence was not controlling, pointing to other ways in which treatment of section 951 inclusions differs from dividends (for example, effect on earnings and profits). The court added that affording qualified dividend treatment would not advance the stated legislative purpose for the preferential interest rate.

The impact of this decision is not necessarily confined to the context of qualified dividends. Rather, its reasoning seems applicable to other contexts in which one might argue that section 951 inclusions should be treated as dividends, but where there is no explicit provision to that effect. And the shoe might be on the other foot. For example, the new health care surtax on investment income for taxpayers earning more than $250,000 defines “net investment income” as including “income from interest, dividends, annuities, royalties, and rents.” I.R.C. § 1411(c)(1)(A)(i). If the IRS would like to impose the surtax on section 951 inclusion income, its victory in Rodriguez would appear to pose an obstacle to that position.

[Note: Miller & Chevalier filed an amicus brief on behalf of American Electric Power in the PPL case.]

We have fallen behind in updating the progress of the litigation concerning the creditability of the U.K. Windfall Tax that was imposed on British utilities in the 1990s. As we previously reported, the Tax Court held in two companion cases that this tax was equivalent to an income tax in the U.S. sense of the term and hence creditable. The government took two appeals — to the Third Circuit in PPL and to the Fifth Circuit in Entergy. Those courts reached opposite conclusions, and PPL has now asked the Supreme Court to grant certiorari to resolve the conflict. (See here and here for previous posts on the parties’ briefing in these cases.)

The Third Circuit was first to rule, in December 2011, and it rejected the Tax Court’s decision in an opinion that rested in large part on arguments not made in the government’s brief. The Third Circuit focused heavily on the details of the three-part test set forth in the regulations, stating that, in focusing on the “predominant character” language in those regulations, the Tax Court had erroneously suggested that the regulation “appl[y] a ‘predominant character standard’ independent of the three requirements.” In that connection, the Third Circuit dismissed the relevance of case law that predated those regulations, notwithstanding language in the preamble indicating that Treasury did not intend to depart from that prior case law. The Third Circuit also criticized PPL’s position that the “flotation value” component of the calculation was not relevant to the three-part test because it merely defined what part of the company’s profits would be taxed as “excess.” The Third Circuit did not deny that this approach would appear to prevent any “excess profits” tax from meeting the test, but it explained that “this argument merely suggests that the regulation misinterprets the statute,” and it was too late for PPL to argue that the regulation is invalid. Finally, the court surprisingly held that the Tax Court’s decision could not be squared with Treas. Reg. § 1.901-2(b)(3)(ii), Ex. 3, an example that illustrates how the gross receipts part of the regulatory test applies in a situation where the tax base is derived indirectly from a quantity that is “deemed” to reflect gross receipts. This example is of dubious relevance to the Windfall Tax, which was based on actual profits, not a “deemed” quantity; the example was not raised in the Tax Court proceedings and was mentioned only tangentially in the government’s brief.

The Fifth Circuit had heard oral argument in Entergy a couple of months before PPL was decided, but did not issue its opinion until June 2012. The Fifth Circuit stated that “the Commissioner’s assertion that we should rely exclusively, or even chiefly, on the text of the Windfall Tax” was contrary to settled case law establishing that the form of the foreign tax is not determinative. “Viewed in practical terms,” the court continued, “the Windfall Tax clearly satisfies the realization and net income requirements.” With respect to the gross receipts part of the test, the Fifth Circuit was “persuaded by the Tax Court’s astute observations as to the Windfall Tax’s predominant character” – namely, to claw back the utilities’ excess profits.

The Fifth Circuit then addressed itself directly to the Third Circuit’s PPL decision, characterizing the latter court’s reasoning as exemplifying “the form-over-substance methodology that the governing regulation and case law eschew.” The example in the regulations relied upon by the Third Circuit is “facially irrelevant,” the Fifth Circuit observed, because “[t]he Windfall Tax relies on no Example 3-type imputed amount, nor indeed on any imputation, for calculating gross receipts.” Thus, although noting that it is “always chary to create a circuit split,” the Fifth Circuit concluded that it had to disagree with the Third Circuit and find the Windfall Tax creditable.

After its petition for rehearing en banc was denied, PPL filed a petition for certiorari on July 9. The petition emphasizes the need to resolve the circuit conflict in order to achieve uniform administration of the tax law and heavily criticizes the Third Circuit for elevating the form of the tax over its substance. For its part, the government has chosen not to seek rehearing in Entergy, bringing the schedules of the cases closer together again. A petition for certiorari in Entergy is now due on September 4. The government’s response to PPL’s cert petition is currently due August 8, but a 30-day extension is likely, which would make the response due on September 7.

The position that the government decides to take in these cases is an important factor in assessing the prospects for a grant of certiorari. Most federal tax cases heard by the Supreme Court involve clear conflicts in the circuits, and it is impossible to deny the existence of such a conflict here. But the Court does not hear every tax case that involves a circuit conflict. Rather, it agrees to hear a case only when it believes that resolution of the conflict is sufficiently important, particularly to the uniform administration of the tax laws. Historically, the Court has afforded considerable deference to the government’s advice on the question of importance. As a repeat litigant at the Court, the government is very selective in asking for Supreme Court review, on the theory that if it does not ask too often, the Court is more likely to grant its requests when it really matters. And the Court does grant a high percentage (in the neighborhood of 70%) of the government’s petitions for certiorari. Thus, in deciding whether to ask the Court to resolve this conflict, the government will weigh its own interests, including estimating its prospects for success if the Court hears the case, and make a judgment about whether it views this issue as important enough to tax administration or to the government’s bottom line to justify using one of its precious “chits.”

Although one might think that the government’s monetary interests could induce it to oppose certiorari in PPL even if were to file a cert petition in Entergy, the Solicitor General’s long-term interest in maintaining credibility with the Supreme Court would trump those short-term monetary interests. Thus, there are two likely courses of action open to the government. Either it will oppose PPL’s petition and not push for Supreme Court review in Entergy or it will file a certiorari petition in Entergy and not oppose PPL’s petition. Unless there are additional extensions, we should know in early September how the government will approach the conflict. The Supreme Court will give its answer several weeks after that.

About Miller & Chevalier’s Tax Appellate Blog

Miller & Chevalier was founded in 1920 as the first federal tax practice in the United States. For nearly 95 years, the firm has successfully represented the most sophisticated corporate clients in all facets of federal income taxation. Miller & Chevalier’s Tax department serves clients headquartered throughout the U.S. and around the world and, over the past several years, has represented approximately 30 percent of the Fortune 100 and more than 20 percent of the Global 100. Our clients come to us to solve the thorniest of tax issues, and we have litigated many of the most significant tax cases on record.

The Tax Appellate Blog is intended to be a resource for information on important tax cases under consideration in the appellate courts. It will feature insightful commentary on the issues and provide a dedicated site for following the progress of these cases.

Authors

Steve Dixon is a Member in the Tax Department at Miller & Chevalier. He specializes in controversy and litigation, representing taxpayers in the Tax Court and Federal courts.

Laura Ferguson is a Member of the Supreme Court and Appellate Litigation Group at Miller & Chevalier and has successfully briefed and argued six cases at the U.S. Courts of Appeals in the past two years. Ms. Ferguson also has extensive experience litigating complex, high-stakes tax cases at the Tax Court and federal district courts.

Alan Horowitz is the former Tax Assistant to the Solicitor General at the Department of Justice, where he briefed and argued numerous tax cases in the Supreme Court. He is currently the head of the Supreme Court and Appellate Litigation Group at Miller & Chevalier.